Six months after the flash crash jolted the stock market and investor nerves, the exchange-traded fund industry continues to grow. That’s despite an uncomfortable fact: Seventy percent of the questionable trades that ended up being canceled involved ETFs.

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BOSTON

Six months after the flash crash jolted the stock market and investor nerves, the exchange-traded fund industry continues to grow. That’s despite an uncomfortable fact: Seventy percent of the questionable trades that ended up being canceled involved ETFs.

Some 21,000 trades from May 6 were wiped away because they appeared to have been executed erroneously. There was no logic to them, just as it didn’t make sense that the Dow Jones industrial average plunged nearly 1,000 points in less than a half-hour.

Yet it was ETFs, not stocks, that were hit the hardest from the sudden drop, federal regulators noted in a report on the crash.

Understanding the role of ETFs in the flash crash requires a grasp of how they work, and how ETFs differ from stocks and mutual funds.

ETFs bundle together the investments that are in a particular market index. Many investors hold them long-term, like mutual funds. But ETFs can be traded during daily sessions just like stocks. That makes it possible to lock in a preferred price without waiting for a closing price, unlike with mutual funds.

ETFs are growing fast. They now number nearly 900, holding nearly $883 billion. That’s up 27 percent from a year ago. ETFs trade across about 50 U.S. exchanges that have increasingly become interconnected, enabling split-second trading.

On a typical day, ETFs make up around 35 percent of the trading volume on U.S. exchanges. So it’s reasonable to expect ETFs would account for a roughly similar proportion of the canceled trades from May 6, rather than twice that amount.

That disconnect requires explanation. That’s especially true when fear of volatility is driving many investors away from stocks, and could hurt ETFs’ surging popularity.

It’s a concern that can’t be ignored, acknowledges James Ross, global head of ETFs at State Street Global Advisors, a unit of Boston-based State Street Corp. and the No. 2 ETF sponsor behind BlackRock Inc.’s iShares ETF business. Ross is at the center of the discussion because he heads the ETF Committee of Investment Company Institute, which has been working with regulators to explore ETFs’ role in the flash crash.

Ross concedes that asking if ETFs were to blame for the flash crash is a fair question, but says the irrational slide in prices of many ETFs wasn’t a cause, but rather a symptom, of the flash crash. Market anxiety was high because of the debt crisis in Greece and elsewhere in Europe. Ross says ETFs became the tool of choice for most big professional investors to offset some of their risk on a day that would have been volatile regardless of trading errors.

Regulators concluded that a single trading firm’s use of a computer sell order triggered the flash crash, setting off a chain of events that ended with market players swiftly pulling money out.

ETF trades were routed to exchanges where there was little cash, or liquidity. That created big gaps between what investors were willing to sell their ETF shares for, and what buyers were willing to pay. Prices for many ETFs went into free-fall.

After the crash, regulators responded with a temporary circuit-breaker program that briefly halts trading of major stocks that make big price swings. They also took steps to ensure consistency among exchanges in the rules used to determine when to cancel trades.

Here are excerpts from an interview with Ross:

Q: Why did ETFs make up a disproportionate share of canceled trades, compared with their normal trading volume?

A: ETFs at that time were just trading significantly more than they traditionally would have because of the volatility of the market. When investors try to hedge (offset investment risk) in volatile times, they’re not thinking of trading individual stocks. They’re thinking, Just get me a hedge. That hedge is usually a broad mix of equities. And that is usually done through ETFs.

For example, the SPDR S&P 500 (the most heavily traded ETF, mirroring the Standard & Poor’s 500 index) saw 81 million shares trade in a 20-minute window on May 6, when it normally would have traded around 7 million in that span.

Generally, ETFs are going to trade more on volatile, down days in the market, because that’s what people use to hedge.

Q: What do you see as the key cause of the crash?

A: The rules in the market infrastructure across the 50 exchanges weren’t consistent. At one point in the day the New York Stock Exchange decided to slow trading. Historically, when securities were just traded on the NYSE, it was a great system — you can slow things down, and make sure everyone has the same information. But when stocks can trade in 49 other places, they go trade there, and they trade in places where there is not as much liquidity.

Q: Could another flash crash happen?

A: The specific situation that drove this, and the challenges we saw with inconsistent rules among exchanges, have been addressed. Can another event happen? Absolutely. I don’t care if it’s trading, or if you’re driving your car and a tire blows out, you can’t always predict what might happen.

Q: Have investors pulled money out of ETFs since the flash crash?

A: Flows didn’t change. Most people understood this was a very unique event.

Q: What advice do you have for investors wanting to trade ETFs, without getting caught up in another market failure?

A: The flash crash reinforced the need for education about the best way to trade ETFs: Using limit orders, and using trading features that are available, but not everyone used during the flash crash.